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Mains Articles

Crypto-currencies and the Regulators Dilemma [Mains Article]

Given the arising interest and enthusiasm of wider populace, technology entrepreneurs and legislators, proscribing cryptocurrencies is unlikely to happen in India. The government will have to take considered steps, given the risks from possible use of crypto currencies in terror financing, money laundering and tax evasion.
By IT's Mains Articles Team
August 23, 2017

Contents

  • What are cryptocurrencies?
  • The Mechanics of Crypto currencies
  • Important Concepts related to Cryptocurrencies:
  • Advantages of cryptocurrencies
  • Risks involved in Crypto currencies
  • Crypto currencies in India: Opportunities, Risks and Policy Options
  • Conclusion

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GS (M) Paper-3: “Challenges to internal security through communication networks, role of media and social networking sites in internal security challenges, basics of cyber security; money-laundering and its prevention”

 

GS (M) Paper-3: “Science and Technology- developments and their applications and effects in everyday life Achievements of Indians in science & technology; indigenization of technology and developing new technology.”

 

What are cryptocurrencies?

  • Crypto-currency is a digital currency that allows transacting parties to remain anonymous while confirming the transaction is valid.
  • These digital payment systems are based on cryptographic proof of the chain of transactions, deriving their name, Crypto currency.
  • These employ cryptographic algorithms and functions to ensure anonymity (privacy) of the users (who are identified by an alphanumeric public key), security of the transactions and integrity of the payment systems.
  • “Decentralised Digital Currency” or “Virtual Currency” is also interchangeably used for a crypto currency.
  • It is not owned or controlled by any institution – governments or private.
  • There are multiple such currencies — Bitcoin, Ethereum and Ripple are some of the popular ones.

ias toppers Virtual Currencies

  • Crypto-currency can be used for a lot of legal activities — such as booking tickets, buying coffee or fast food, depending of which retailers accept such currency.
  • The valuation of the crypto currency Bit coin founded a year later would surge to 2300 USD a unit in less than a decade.

ias toppers cryptocurrencies

The Mechanics of Crypto currencies

  • Crypto currency is fundamentally a decentralised digital currency transferred directly between peers and the transactions are confirmed in a public ledger, accessible to all the users.
  • Any exchange of currency, between party A and party B is a transaction. A cryptographic algorithm/function encrypts this transaction using the digital signatures of the parties to establish their authenticity.
  • Once validated, the transaction reflects in the public ledger, maintained by so-called miners.
  • As a privacy measure, the transactions do not reveal the identities of the parties, but rather uses their cryptographic signatures or hash to identify them while maintaining their anonymity.
  • The transactions do not disclose any details of the parties, be it the name, gender, location signature, credentials or nationality.

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Important Concepts related to Cryptocurrencies:

Open Source

  • Cryptocurrencies developed with the open source methodology have their software source code available for open review, integration, development and enhancement.

Miners

  • They are the backbone of a cryptocurrency. Mining is the process of ledger keeping and validating transactions. It is also a truly decentralised and distributed process, open to everyone.
  • Every new block in the chain brings a monetary reward to the miner whose block is accepted, and this injects wealth into the cryptocurrency system.
  • The process of mining also generates value for the miners in the form of transaction fees, which is optional and very low as compared to traditional banking systems.

iastoppers-bitcoin-mining

Proof-of-work

  • Proof-of-work is just a small set of data which is difficult to compute but quite easy for others (peers) in the network to verify.
  • Miners have to complete a proof-of-work on the present block of transactions, for their block to be accepted by other nodes in the network as legitimate.

Blockchain Technology

  • A blockchain is the electronic ledger which maintains record of all the transactions from the time the first unit of the cryptocurrency – the seed – was mined.
  • Blockchain is fundamentally a technology which not just empowers cryptocurrencies, but has found diverse applications as a digital ledger providing a secure way of making and recording transactions, agreements, contracts and land records.
  • Being a digital ledger, a blockchain can be decentralised and distributed, enabling storage of multiple copies across the network.
  • Like cryptocurrencies, the underlying blockchain technology is also considered to be a disruptive innovation.

How a blockchain works

Advantages of cryptocurrencies

Privacy Protection

  • In cryptocurrencies, the use of pseudonyms conceals the identities, information and details of the parties to the transaction – perquisites for privacy enthusiasts.

Cost-effectiveness

  • Cryptocurrencies have single valuation globally, and the transaction fee is extremely low, being as low as 1% of the transaction amount.
  • Cryptocurrencies eliminate third party clearing houses or gateways, cutting down the costs and time delay.
  • All the transactions over cryptocurrency platforms, whether domestic or international, are equal.
  • Another facet, which brings the cost down considerably low, is inbuilt security and fraud prevention mechanism, which accounts for 40% of the costs of payment processing gateways.

Lower Entry Barriers

  • Possessing a bank account or a debit/credit card for international usage requires documented proofs for income, address or identification. Banks or financial institutions might have their own set of eligibility criteria for these facilities. Cryptocurrencies lower these entry barriers, they are free to join, high on usability and the users do not require any disclosure or proof for income, address or identity.

Alternative to Banking Systems and Fiat Currencies

  • Cryptocurrencies offer the user a reliable and secure means of exchange of money outside the direct control of national or private banking systems.

Open Source Methodology and Public Participation

  • A majority of the cryptocurrencies are based on open source methodology, their software source code is publicly available for review, further development, enhancement and scrutiny.
  • The ecosystem of cryptocurrencies is primarily participation based, as software development, bug reporting and fixing, testing etc. are driven by the wider user base, rather than a closed set of individuals or an institution.

Immunity to Government led Financial Retribution

  • Governments have the authority and means to freeze or seize a bank account, but it is infeasible to do so in the case of cryptocurrencies.

iastoppers bitcoins advantages

Risks involved in Crypto currencies:

Key/Wallet/Exchange Security:

  • A virtual wallet stores the keys and transaction records of the user. The secure digital keys are used to access the public address and to sign or authenticate the transactions initiated by the user. Virtual wallets exist in the forms of desktop wallets, Web-based wallets and mobile wallets.

Hijacking/Routing Attacks/Distributed Denial of Service (DDoS) attacks on Crypto currency System:

  • Crypto currency systems are open source and the pooled in resources of the miners keeps these systems up and running.

Uncertain Regulatory Environment:

  • The future and further success of crypto currencies depends upon the way regulatory frameworks are devised.

Lack of Liquidity and Lower Acceptability:

  • Crypto currencies function outside banking systems, beyond the regulations or controls of the regulatory agencies.

Price Volatility:

  • Volatility, a measure of variance of the price of a financial instrument over a certain period of time, is associated with the risk level of the instrument.
  • High volatility is regarded as risky, and crypto currencies are known to be extremely prone to price fluctuations.

Uncertainly over Consumer Protection and Dispute Settlement Mechanisms:

  • Crypto currencies are decentralised, that means, there is no single authority for mediation or dispute redressal.

Crypto currencies in India: Opportunities, Risks and Policy Options

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Actions taken in India:

  • The Reserve Bank of India, in 2013, had issued a warning to individuals dealing with virtual currencies in India on the financial, legal, operational and security-related risks.
  • RBI warned that this could even subject the users to unintentional breaches of anti-money laundering and combating the financing of terrorism laws.
  • It further reiterated this stand in 2017, again cautioning users, holders and traders of Virtual Currencies about the potential financial, operational, legal, customer protection and security related risks.
  • The RBI clarified that it has not given any licence or authorisation to any entity/company to operate such schemes or deal with Bitcoin or any virtual currency.
  • Owing to the rising concerns, the government of India has set up a committee to take stock of the present status of Virtual Currencies both in India and globally; examine the existing global regulatory and legal structures; and suggest measures (related to consumer protection, money laundering, etc).
  • Apart from this committee, there is also a Parliamentary Standing Committee on Finance which is looking into these developments.

Factors shaping policy on cryptocurrencies in India:

  • the thrust of the government towards Digital economy, driven by the flagship programs of the government for financial inclusion;
  • the risks of tax evasion, given the stringent regulations in the past one year for the crackdown on black and unaccounted money; and
  • the present security situation and experience with terrorism or Left Wing Extremism.

Opportunities and Risks associated with cryptocurrencies in India:

  • Given the arising interest and enthusiasm of wider populace, technology entrepreneurs and legislators, proscribing cryptocurrencies is unlikely to happen in India.
  • In India, the prominent security threats, in form of terrorism and left wing extremism, might bring in some hesitation in the early phase of adoption or integration of this technology with the financial system.
  • Regulated cryptocurrencies will enshrine robust consumer protection provisions. In terms of benefits, this could be a force multiplier in India’s quest for financial inclusion, parallel to the electronic payment modalities such a digital wallets and Adhaar Enabled Payment System.
  • It could further reduce the cost associated with remittances, which brings annual earnings of close to 62 billion USD to India.
  • It would also attract future business entrepreneurs, leading to innovation, generation of job and wealth creation in the due process of payments processing, e-commerce and taxation.

What will be the future discourse on cryptocurrencies?

There are three probable directions in which the future discourse on cryptocurrencies will advance; that governments will:

  1. Let cryptocurrencies proliferate as per the market dynamics, without any intervention;
  2. Regulate this segment, designate a status such as legal instrument or capital asset with safeguards for protection against the risks like terror financing, illicit trade or tax evasion;
  3. Proscribe them, given the security risks to the state and perils to the users from volatility, liquidity and security of the assets/systems.

Conclusion

  • Crypto currencies are a disruptive innovation that has already begun to alter the existing means of electronic payments, money transfers, policies and regulations. India has also moved a step forward in this regard by considering legalising of these currencies. The government will have to take considered steps, given the risks from possible use of crypto currencies in terror financing, money laundering and tax evasion. 
[Ref: EPW]

 

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